An AFD Auditors Explanation of the Impact of IFRS 16 on Financial Statements

IFRS 16 applies to annual reporting periods beginning on or after 1 January 2019. Earlier adoption was permitted, provided the entity also applied IFRS 15 Revenue from Contracts with Customers at or before that date. The standard has now been in effect for several years and is the established basis for lease accounting for Audit Firms in Dubai and other users of financial statements.

What Is IFRS 16?

IFRS 16’s purpose is to help UAE company audit specialists represent lease-based transactions accurately and support users in assessing the cash flows arising from leases. The standard requires a lessee to recognize assets and liabilities for leases with a term of more than 12 months, unless the underlying asset is of low value. The lessee recognizes a right-of-use asset representing its right to use the underlying asset, and a lease liability representing its obligation to make lease payments.

Lessees measure right-of-use assets in broadly the same way as other non-financial assets, such as property, plant, and equipment. Lease liabilities are measured similarly to other financial liabilities. The lessee depreciates the right-of-use asset, usually on a straight-line basis, and recognizes interest on the lease liability separately. Under IAS 7, cash payments for the principal portion of the lease liability are classified within financing activities, while interest payments are classified according to the entity’s accounting policy for interest under IAS 7, which can be operating, investing, or financing.

Initial measurement of the lease asset and liability is based on the present value of the lease payments. This includes non-cancellable payments and inflation-linked payments where applicable. Auditors in Dubai should also factor in optional extension or termination periods where the lessee is reasonably certain it will exercise that option.

The right-of-use asset is presented in the statement of financial position either within property, plant, and equipment or as a separate line item. Lessors, by contrast, continue to classify their leases as finance or operating leases and account for them accordingly, IFRS 16 changed lessee accounting far more than lessor accounting.

Sectors Most Affected by IFRS 16

Under the previous standard, IAS 17, most leases were disclosed only in the footnotes to the financial statements. Under IFRS 16, most leases are now recognized directly on the balance sheet as right-of-use assets and lease liabilities. This has had a meaningful effect on financial metrics such as gearing ratios, EBITDA, and return on assets. Sectors that rely heavily on operating leases for off-balance-sheet financing, airlines, transport, and telecommunications among the most exposed in the UAE, felt this impact more than most.

Also check: Statutory Audit Services in Dubai

How IFRS 16 Affects a Lessee’s Financial Statements

The most significant effect of IFRS 16 is an increase in reported financial liabilities and lease assets. Companies with previously significant off-balance-sheet leasing arrangements see a meaningful shift in the financial metrics derived from their reported assets and liabilities.

Balance Sheet Impact

IFRS 16 affects both sides of the balance sheet. The lessee recognizes a new category of assets for the right-of-use asset, along with the related lease liability. Companies in Dubai and the UAE that previously kept operating leases off the balance sheet now see both assets and liabilities increase.

The carrying amount of the right-of-use asset typically declines faster than the carrying amount of the related lease liability over the lease term, since the asset is depreciated on a straight-line basis while the liability reduces more slowly in the early years as interest makes up a larger share of each payment. For companies with material off-balance-sheet leases previously, this generally reduces reported equity relative to what would have been reported under IAS 17.

Statement of Profit or Loss

Under IAS 17, operating lease expense was recognized as a single operating expense line. Under IFRS 16, that single expense is replaced by two separate items: depreciation of the right-of-use asset, an operating expense, and interest expense on the lease liability. The depreciation charge is typically even across the lease term, while interest expense declines over time as the outstanding lease liability reduces with each payment. The combined effect is a reduction in total lease expense in the later years of the lease compared to the earlier years.

Because part of what was previously a single operating expense under IAS 17 is now classified as interest expense, sitting below EBITDA, reported EBITDA and EBIT both tend to increase under IFRS 16 compared to the old treatment. Analysts and valuation professionals should account for this when comparing valuation multiples based on EBITDA or EBIT across companies that adopted IFRS 16 at different times, or against companies still reporting under older frameworks.

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Statement of Cash Flows

IFRS 16 does not change the actual amount of cash transferred between the parties to a lease, and it doesn’t change the overall split between operating, investing, and financing cash flow categories in principle. What does change is classification: under IAS 17, cash outflows relating to operating leases were reported within operating activities. Under IFRS 16, principal repayments on lease liabilities are reported within financing activities instead, with interest classified per the entity’s IAS 7 policy. In practice, this tends to reduce reported operating cash outflows and increase financing cash outflows compared to the equivalent figures under IAS 17.

IAS 17 vs. IFRS 16: Summary

Statement	Under IAS 17	Under IFRS 16
Balance Sheet	Operating leases largely off-balance sheet	Right-of-use asset and lease liability recognized on-balance sheet
Profit or Loss	Single operating lease expense	Split into depreciation (operating) and interest expense
Cash Flow	Lease payments within operating activities	Principal within financing; interest per IAS 7 policy
Key metrics affected	N/A	Gearing ratios, EBITDA, EBIT, and return on assets typically increase or change

Worked Example

A Dubai airline previously reported an aircraft operating lease entirely off-balance sheet under IAS 17, with a flat annual lease expense of AED 10 million recognized in operating expenses. Under IFRS 16, the airline instead recognizes a right-of-use asset and a lease liability, both initially measured at the present value of the lease payments. Instead of a single AED 10 million operating expense, the income statement now shows straight-line depreciation of the right-of-use asset plus a separate interest expense on the declining lease liability, with the interest portion higher in the early years and lower toward the end of the lease term. Reported EBITDA rises because the depreciation and interest components now sit below the EBITDA line, while the balance sheet shows meaningfully higher assets and liabilities than it did under IAS 17.

Also check: Financial Statement Audit Services in Dubai

Common Mistakes When Assessing IFRS 16’s Impact

• Comparing EBITDA across companies without adjusting for lease accounting. A company with heavy historical operating lease use will show a larger EBITDA jump under IFRS 16 than a company that owned most of its assets outright.
• Assuming cash flow totals change. IFRS 16 reclassifies lease cash flows between categories, it doesn’t change the total cash paid.
• Overlooking the low-value asset exemption. Not every lease needs to go on the balance sheet, low-value underlying assets remain eligible for the simplified treatment.
• Ignoring the interest classification policy choice. How interest on the lease liability is classified in the cash flow statement depends on the entity’s own IAS 7 policy, not a fixed IFRS 16 rule.

Frequently Asked Questions

Does IFRS 16 change how much cash a lessee actually pays for a lease?

No. It changes how that cash flow and the related expense are classified and presented, not the underlying amount paid.

Why does EBITDA typically increase under IFRS 16?

Because operating lease expense, previously a single line above EBITDA under IAS 17, is now split into depreciation and interest, both of which sit below the EBITDA line.

Are all leases required to go on the balance sheet under IFRS 16?

No. Leases of 12 months or less, and leases of low-value underlying assets, are exempt from on-balance-sheet recognition.

Which sectors were most affected by the shift to IFRS 16?

Sectors that relied heavily on operating leases for off-balance-sheet financing, particularly airlines, transport, and telecommunications, saw the most significant impact.

How is interest on a lease liability classified in the cash flow statement?

Based on the entity’s own accounting policy under IAS 7, interest can be classified as operating, investing, or financing.

Assessing IFRS 16’s Impact on Your Financial Statements

The numbers behind an IFRS 16 transition rarely surprise anyone at the total level, cash paid doesn’t change. Where companies get tripped up is in how the reclassification affects ratios lenders and investors actually watch, gearing, EBITDA, and return on assets among them.

Qualified specialists at AFD Auditors can review how your leases have been classified and measured under IFRS 16, and flag where the resulting metrics need explaining to lenders or investors before they ask.